Adding New Asset Classes to Your Portfolio

NOVEMBER 13, 2013
James M. Dahle, MD, FACEP
The benefits of having several different asset classes in your portfolio are well-known. There are dozens of increasingly exotic asset classes available to invest in, including frontier market stocks, U.S. small growth stocks, Japanese real estate, and British inflation-indexed bonds. An investor need not invest in all of them in order to be successful in reaching his financial goals.
 
The point of holding multiple asset classes is to boost returns and decrease risk through diversification. Since neither you, nor I, can predict the future, you want a portfolio that is going to do acceptably well no matter what happens in the world.
 
Consider these guidelines when deciding whether or not to add a new asset class to your portfolio.
 
Number of asset classes
If your portfolio currently contains only one or two asset classes, you will almost surely benefit from adding another one.
 
Although the benefit of adding an additional asset class to the portfolio goes down with each new asset class, the benefits can be dramatic initially. As you add more classes, you are weighing the additional diversification against the added complexity and expenses inherent in a more complicated portfolio.
 
An investor with a tiny portfolio relative to what he will eventually need to retire can start out with a single asset class, since the effect of additional savings will dwarf the effect of the investment returns of the portfolio. As the portfolio grows, he will want to consider additional asset classes to provide diversification.
 
As a general rule for a portfolio of reasonable size, I would consider a bare minimum of three different asset classes. Seven asset classes provide a great balance between diversification and complexity. There is very little additional benefit to additional asset classes once you get to 10. Rather than adding an additional class to an already complex portfolio, perhaps you should consider replacing one that you currently have instead.
 
Avoid performance chasing
The addition of new asset classes to a portfolio is often used as an excuse by the investor to engage in the harmful practice of performance chasing. Investors consciously and subconsciously project the recent past into the future, despite the well-known fact that past performance is no indication of future returns. As such, it was popular to add small value stocks and REITs to portfolios in 2003-2007 and to add gold and long-term treasuries to portfolios in 2010-2012.
 
These days, after nearly five years of outstanding stock performance, investors are talking about a “100% equity” portfolio again. While adding any of these asset classes to your portfolio may make sense for the long run, be sure to carefully examine your motivation to ensure you’re not just chasing performance. If you’re convinced an asset class belongs in your portfolio, consider adding it after a period of poor performance, rather than when it is the “hot” asset class.
 
Low correlation
When adding an asset class you want to make sure it is fundamentally different from what you already own.
 
Bonds are loans to companies or governments. When you own a stock, you own part of a company and share in its profits. REITs invest primarily in real estate and have a different tax structure than a more typical stock. It is easy to argue these asset classes are fundamentally different. Likewise, long-term Treasury bonds have different risk characteristics than short-term corporate bonds. You’re looking for asset classes with relatively low correlation with one another.
 
On the other hand, if you have a portfolio consisting of large growth stocks and small value stocks, adding some large value stocks (which have relatively high correlation with the other asset classes you hold) probably isn’t going to get you the bang for the buck you would get from adding some bonds or real estate (which have much lower correlation with the stocks you already hold).
 
Historical correlations are relatively easy to look up. Correlations vary over time, but you’re looking for an asset class that is non-correlated with your current asset classes as much as possible.
 


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